Currency overlay: an introduction

Wednesday, May 03, 2006

Louise Harris, Currency Overlay Research and Development Manager

at Millennium Global Investments Ltd., sets out some of the basics of
the strategy.

Everywhere in the universe, there is uncertainty; and everywhere, in

response, a frail humanity, unable to align psychology with mathematics,
cowers in anxiety. It doesn't cower entirely passively, though. It is prepared
to go to considerable lengths to reduce the extent of the perceived threat to
its mental composure. Arguably, agriculture and science have developed
on the back of society's insistent search for security; likewise religion and
politics.

Unsurprisingly, the same tendencies are apparent in finance. The growth of

the insurance sector in earlier centuries – and of hedge funds in recent
ones – is testimony to the public's dislike of uncovered risk and its
willingness to pay for security. The man who insures his house against fire
'expects' to lose financially by doing so: he knows that the premiums he will
pay are high in relation to the benefit he will probabilistically receive. But his
psychology is non-linear: he rates the loss of his house as being so
intolerable that he is willing to pay 'over the odds' for protection. He
dismisses standard mathematics. He worries more about low probability
events of devastating expense, and is relatively nonchalant about high
probability ones of tolerable cost.

Currency overlay fits comfortably into this analysis. It provides insurance

against a – usually – low probability occurrence of serious proportions. The
irony is that the need for it has arisen from investors' prior search for
serenity via diversity.

During the second half of the last century, there was a wholesale
globalisation of portfolio assets. Instead of investors buying predominantly
domestic securities, they started acquiring them from elsewhere in the
world. The rationale was that the correlation of returns across national
borders was relatively low and that a more mixed portfolio could therefore
earn a higher reward for any given level of uncertainty.

In principle, investors are right to diversify their assets internationally, but

many of them fail to anticipate that, by doing so, they encounter extra
volatility from a new source: currency movements. The solution to their new
problem, though, is relatively straightforward. It involves nothing more than
the purchase of a foreign exchange related insurance policy, otherwise
known as currency overlay.

What is currency overlay?

Currency overlay is the management of currency risk already existing in an
international portfolio. This involves managing the currency exposures
separately from the underlying assets. The risk inherent in the portfolio
stems from the fact that portfolio managers seek diversification from
international assets. For example, the global equity manager of a UK
pound sterling-based investor may decide to overweight its exposure to US
equities; this decision is based on the prospects for the US equity market
and on the prospect for the US dollar. The investment may appreciate by
10% in US dollar terms during the holding period, but if the US dollar has
depreciated by 10% versus the UK pound sterling in the same period, the
return generated for the investor will have been completely wiped out by
the currency movement! It is this risk that needs to be managed separately.

Active currency overlay is a relatively new dedicated investment activity,

with the first mandates awarded in the mid to late 1980s. Many investors
had previously ignored the underlying currency risk in their international
portfolios, believing that currency effects wash out over time. They
generally do, but over many years, a much longer time period than most
investors' investment horizon. Fluctuations during that time can be very
large, and subsequent losses not acceptable to the investor, whilst
presenting opportunities for skilled managers to exploit. The objective of
active currency overlay managers is to limit currency losses and maximise
currency gains.

Options for currency management

Once an investor has recognised the risk from currencies that are inherent
in his portfolio, a decision needs to be made as to what to do about this
risk. There are three options:
• To do nothing, which is the riskiest position, leaving the portfolio with
random returns. An analysis conducted by Mercer Consulting shows that
countries with the best performing equity markets also tend to have the
weakest currencies. This approach, often associated with international
equity investing, is clearly less than optimal;
• To passively hedge, which is easy to do and negates the currency risk,
but reduces diversification benefits from international investing – effectively
creating synthetic domestic assets, thereby exposing the investor solely to
local market returns, and ignoring both diversification and the potential
added returns from active currency management;
• Active Currency Overlay enables the investor to just do that. Firstly, a
hedge ratio for his international portfolio must be chosen that reflects the
investor's desired neutral currency exposure. Secondly, a set of parameters
is designed to allow the active currency manager to deviate from this
neutral benchmark in order to generate alpha.

Let us take a UK pound sterling-based investor as an example, with a 20%

exposure to the US dollar. Let us assume he decides to have a 50% hedge
ratio. As a neutral exposure, the currency overlay manager will hedge 10%
of the US dollar exposure (50% of 20%). When the manager expects the
UK pound sterling to appreciate against the US dollar, he will hedge more
than 50% of the exposure, possibly going up to 100% if he has a strong
conviction. Conversely, when the currency overlay manager believes that
the UK pound sterling will depreciate versus the US dollar, he will reduce
the hedge from 50%, possibly going as low as 0%, thereby capturing alpha
during times of UK pound sterling appreciation and depreciation.

The more latitude a manager is allowed around the benchmark, the greater
the potential for alpha. For example, allowing cross-hedging and proxy-
hedging, as well as the opportunistic use of emerging currencies, will give
the manager more latitude to implement his views and generate better risk-
adjusted returns.

This example raises the important question of the optimal benchmark

hedge ratio.

The optimal benchmark hedge ratio decision

The benchmark for a currency overlay programme serves not only as a
basis for performance measurement but, more importantly, as the neutral
position when the currency overlay manager has no view. In order to assist
an investor to select the optimal benchmark hedge ratio, the currency
overlay manager will take into account a number of variables: the
proportion of the investor's total assets invested internationally; historic
risk/return analysis over an appropriate time period, as well as prospective
returns; correlations between the different asset classes in the portfolio;
cash flow implications of different hedging strategies, etc.

The options for the benchmark include: unhedged, 0%; fully hedged, 100%;
as well as somewhere in-between. The 50% hedged benchmark is often
referred to as the hedge ratio of 'least regret'. If the base currency
appreciates, a 50% hedged benchmark will benefit from half of that
appreciation; if the base currency depreciates, the 50% hedged benchmark
will only lose half as much. Also, a 50% hedge benchmark combined with
symmetric guidelines – eg. say +/-30% deviation from the chosen hedge
ratio – will be optimal for the active manager to reduce risk from currency
fluctuations and to seek to add value.

Does currency overlay work?

Studies carried out by consultants have yielded some interesting results.

A research paper published by Russell Investment Group in 2000 showed

that the average active currency overlay manager added 1.04% per
annum. This research paper was updated by Russell/Mellon (Mellon
Analytical Solutions) in 2003 and the average annualised return had not
changed much (0.97% per annum). The survey also highlights the fact that
currency managers' skills at converting risks into returns tend to be superior
to those of active managers of either bonds or equities portfolios.
Information ratios for the whole universe of currency overlay managers are
much higher than in other asset classes.

The chart above illustrates rolling year excess returns generated by active
managers of bonds, equities and currency overlay programmes. Although
the returns from the currency overlay universe tend to be more episodic,
they have clearly outperformed the two more 'traditional' asset classes.

How are currency overlay managers able to add value?

Currency markets are the largest and most liquid markets in the world,
hence, arguably, the most efficient. This is not so. There is a peculiar set of
participants in currency markets whose utility function is not to make a
profit. These participants include:
• Central banks, whose aim is generally to control inflation and who often
intervene in currency markets to strengthen or weaken their domestic
currency and, in some cases, to defend a certain level or peg;
• Corporate treasurers who are repatriating profits or hedging orders and
receivables, and often do not have a choice of when to participate in the
currency markets;
• Equity managers, who may be forced to buy and sell foreign currency
every time the constituents of an index change; and
• Tourists, who rarely choose their foreign holidays based on their view of
the foreign exchange markets.

All of these participants leave opportunities that skilled currency overlay

managers can exploit. The utility functions of the above participants will not
change. Therefore, it seems reasonable to expect that the opportunities
available to active currency managers will continue. They may diminish
slightly with the advent of new entrants in the market, but the more skilled
and experienced managers will continue to capture these opportunities and
generate alpha.
Summary
In summary, currency overlay is the management of currency risk already
inherent in the portfolio. There are three options open to an investor faced
with currency risk: do nothing; passively hedge; or look at active
management. If active management is the chosen option, a suitable
benchmark hedge ratio must be chosen, and as much latitude as possible
around this benchmark will ensure that the potential to reduce currency risk
and generate alpha by the active currency overlay manager will be
optimised.

Consultants' studies have shown that active currency overlay managers

add around 1% per annum, with much higher information ratios than in
conventional asset classes. Currency markets are likely to continue to offer
opportunities for skilled and experienced managers to exploit, due to the
presence of non-profit maximising participants in the markets.

Implementing a currency overly mandate is very straightforward and, as

mandates are not funded, is very cost-effective. The margin required is less
than 10% and can be in the form of cash or cash plus bonds, or through the
opening of a credit line with a bank.